second edition chapter 1 the big ideas. understand your world many of the most important issues in...
TRANSCRIPT
•Second EditionChapter 1Chapter 1
The Big IdeasThe Big Ideas
Understand Your WorldUnderstand Your World
Many of the most important issues in the world today cannot be understood without understanding economics.
The text uses the following icon to emphasize the most important ways in which economics helps us understand the world.
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Chapter OutlineChapter Outline
1. Incentives matter
2. Good Institutions align self interest with social interest
3. Trade-offs are everywhere
4. Thinking on the margin
5. The power of trade
6. The importance of wealth and economic growth
7. Institutions matter
8. Economic booms and busts cannot be avoided but can be moderated
9. Prices rise when the government prints too much money
10. Central banking (central planning) is a hard job
The Biggest Idea of All: Economics is Fun
•3
IntroductionIntroduction
1787—The British government hired sea captains to transport prisoners to Australia.• Their pay was determined by the number of
prisoners transported.• Result:
As many as one third of prisoners died en route. Survivors arrived starved, beaten, and ill.
There was an outcry in Britain.• Newspapers editorialized.• Clergy appealed to the captains.• Parliament passed regulations.
Result: Nothing changed.
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Incentives in the Prisoner Incentives in the Prisoner Transport BusinessTransport Business
The British prison transport vessel “Success”The British prison transport vessel “Success”
This situation eventually changed. What caused it to change?
• Incentives changed – How?
This illustrates the first of ten generally accepted principles: incentives matter.
Incentives - rewards and penalties that motivate behavior.
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IntroductionIntroduction
Big Idea Two: Good Institutions Align Self Big Idea Two: Good Institutions Align Self Interest with the Social InterestInterest with the Social Interest
When self interest aligns with the broader public interest, we get good outcomes. • Markets channel self-interest of millions of
people. • Adam smith described this coordination as the
“invisible hand”. Ways in which people acting in their self
interest produce outcomes that are good for all of us are denoted by:
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Invisible handSee the
Big idea #2: Good Institutions Align Big idea #2: Good Institutions Align Self-interest with the Social InterestSelf-interest with the Social Interest
Markets magically align your self-interest with social interest (usually)
Because the cheese-monger wants profit; you get your cheese!
SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND
SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND
Adam Smith saw the invisible hand
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”
-Adam Smith,
The Wealth of Nations
Big Idea Two: Good Institutions Align Self Big Idea Two: Good Institutions Align Self Interest with the Social InterestInterest with the Social Interest
Markets do not always align self-interest with the social interest• Sometimes market incentives are too strong.
External costs: e.g. pollution Overutilization of commonly held resources (the
“tragedy of the commons”)
• Sometimes market incentives are too weak. External benefits.
• Example: Flu shots
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Big Idea Three: Trade-offs Are EverywhereBig Idea Three: Trade-offs Are Everywhere
September 2004: Merck withdrew Vioxx, an arthritis drug from the market• Vioxx could cause strokes and heart attacks.
• Many people demanded more testing.• Economists worried that approved
pharmaceuticals could become too safe.
Huh? How can drugs be too safe?• Economists consider two important trade-offs:
Drug lag Drug loss
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Big Idea Three: Trade-offs Are EverywhereBig Idea Three: Trade-offs Are Everywhere
Trade-offs are closely related to opportunity cost.• Opportunity cost - The value of what you give
up when you make a choice. Example: The biggest cost of college is forgone
income.
Opportunity cost is important for two reasons…
1.Helps us evaluate trade-offs.
2.Helps us understand behavior
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Big Idea Three: Trade-offs Are EverywhereBig Idea Three: Trade-offs Are Everywhere
To understand behavior, you must understand opportunity cost.• Application: What would you expect to happen
to college enrollment during a recession? The opportunity cost of going to college falls
during a recession. Why? The reverse is true—The opportunity cost of going
to college rises when the economy is booming. Prediction: college enrollments ↑ when
unemployment ↑ and ↓ when unemployment ↓. The next figure shows this is true.
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Big Idea Three: Trade-offs Are EverywhereBig Idea Three: Trade-offs Are Everywhere
14
-15
-10
-50
510
1960 1970 1980 1990 2000Year
Percentage Deviations from Trend, 1960-2000The College Enrollment Rate Tends to Increase
When the Unemployment Rate Increases
Enrollment Rate
Unemployment Rate
Source: National Center for Educational Statistics and Bureau of Labor Statistics
Note: Enrollment rate of high school completers and January unemployment rate among 16-19 yr olds.
Big Idea Four: Thinking on the MarginBig Idea Four: Thinking on the Margin
Making choices by comparing the extra benefit to the extra cost of an action.• We engage in marginal thinking all the time.
Example: adjusting our speed while driving. What are the benefits and costs of driving faster or slower?
Understanding human behavior requires looking at the trade-offs people face.
Trade-offs usually involve choices about a little bit more or a little bit less.
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Big idea #4: Big idea #4: Thinking on the MarginThinking on the Margin
Actual trade-offs are usually “on the margin.”
Marginal means additional Most economic choices are
marginal choices E.G. Newt Gingrich wanted
mandatory executions for drug dealers…
but the effect would be to reduce the EXTRA penalty for murdering police offers during arrest
Higher punishments for lesser crimes reduce the marginal cost of harsher crimes.
Big Idea Four: Thinking on the MarginBig Idea Four: Thinking on the Margin
Application• Say you have graduated and are earning $64,000
a year.
• You are offered another job at a higher salary, but it’s in a different city and you don’t want to move.
• Should you take the job? Depends on…
• How much of the additional income you get to keep after taxes (marginal benefit).
• What you give up to move i.e. friends, family, lower cost of living (marginal cost)
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Big Idea Five: The Power of TradeBig Idea Five: The Power of Trade
Both people involved in voluntary exchange are better off.
The power to increase production through specialization.• Why is it unlikely that Martha Stewart irons her
own clothes even though she is likely very good at ironing?
• Specialization is important for countries as well as individuals.
Allows us to take advantage of economies of scale.
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Big Idea Six: The Importance of Wealth and Big Idea Six: The Importance of Wealth and Economic GrowthEconomic Growth
2007—more than half a billion people contracted malaria.• About a million—mostly children—died.• Malaria was once common in the U.S..
Wealth ended it Lesson: Wealthier countries have…
• Lowest infant mortality rates.• Greatest access to sanitation facilities,
antibiotics, education, fulfilling jobs and careers. In short: Wealth matters..understanding
economic growth is crucial
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Big idea #6: Big idea #6: The Importance of Wealth and The Importance of Wealth and Economic GrowthEconomic Growth
http://www.youtube.com/watch?v=jbkSRLYSojo
Hans Rosling's famous lectures combine enormous quantities of public data with a sport's commentator's style to reveal the story of the world's past, present and future development. (4:48 minutes).
BACK TO
Big Idea Seven: Institutions MatterBig Idea Seven: Institutions Matter
What makes a country rich?• Most proximate causes:
large amounts of physical and human capital. Things are produced in a relatively efficient manner. Use of the latest technological knowledge.
Why do some countries have more physical and human capital organized well using the latest technology?
Answer: Differences in incentives.
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Big Idea Seven: Institutions MatterBig Idea Seven: Institutions Matter
How do incentives help create wealth?• Entrepreneurs, investors, and savers need
incentives to save and invest Important institutions that support good
incentives are…• property rights,• political stability,• honest government,• dependable legal system,• competitive and open markets.
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North and South Korea at night
Can you tell which country has better institutions?
Big Idea Seven: Institutions MatterBig Idea Seven: Institutions Matter
South and North Korea were equally poor in 1950.• South Korea - modern developed country with
per capita income 10 times greater than North Korea’s.
• North Korea - starvation is common and people can go months without eating meat.
• They share the same language and culture and historical background. What’s the difference?
• Their economic systems and incentives
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Big Idea Seven: Institutions MatterBig Idea Seven: Institutions Matter
Macroeconomists are especially interested in the incentives to produce new ideas.• New ideas are the lifeblood of economic growth.
• Without new ideas standards of living worldwide will stagnate.
Ideas have peculiar properties• Ideas can be shared without limit.
One apple feeds one man; one idea can feed the world.
• Ideas are not used up.
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Big Idea Eight: Economic Booms and Busts Big Idea Eight: Economic Booms and Busts Cannot be Avoided but Can Be ModeratedCannot be Avoided but Can Be Moderated
No economy grows at a constant pace.• Booms and busts are part of the normal response
of an economy to changing economic conditions. Not all booms and busts are normal.
• The Great Depression was not normal. National output fell by 30 percent. Unemployment exceeded 20 percent. Stock market fell to less than a third of its original value.
• The Great Depression did not have to happen. Most economists believe that appropriate monetary and
fiscal policy could have made it shorter and less deep. Monetary and fiscal policies were not well understood at
the time.26
Today, monetary and fiscal policy are much better understood.• When used appropriately, they can reduce
swings in unemployment and GDP.• When used poorly, they can make recessions
worse and the economy more volatile.
Significant task of macroeconomic theory.• To understand the promise and limits of
monetary and fiscal policy.
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Big Idea Eight: Economic Booms and Busts Big Idea Eight: Economic Booms and Busts Cannot be Avoided but Can Be ModeratedCannot be Avoided but Can Be Moderated
Big Idea Nine: Prices Rise When the Government Big Idea Nine: Prices Rise When the Government Prints Too Much MoneyPrints Too Much Money
Inflation - an ↑ in the general level of prices.
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Zimbabwe Billionaire
• One of the most common problems of macroeconomics.
Inflation is caused by a sustained increase in the money supply.• In the U.S. the money supply is
controlled by the Federal reserve. Low inflation since the early 1980s is a
testament to successful Fed policy.
• In Zimbabwe the government was printing money so rapidly that in 2009 prices were rising by billions of percent per month!
Big idea #10: Big idea #10: Central Banking Is a Hard JobCentral Banking Is a Hard Job
The Federal Reserve is the U.S.’s central bank.
“The Fed” is in charge of money supply• Helping the economy be stable• Balancing inflation and unemployment• Preventing banking crises?
Ben Bernanke, Chairman of the Fed, wondering where the nearest aspirin supply is.
The Federal Reserve Bank (“the Fed”) is often called on to combat inflation.• A challenge because there is a lag between
when the Fed makes a decision and when the effects of the decision on the economy are known.
• It is difficult to make the right guess about where the economy is going. If the Fed gets it wrong, it can make things worse.
• It is wise to think of the Fed as a highly fallible institution that faces a very difficult job.
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Big Idea Ten: Central Banking Is a Hard JobBig Idea Ten: Central Banking Is a Hard Job
The Biggest Idea of All: Economics is FunThe Biggest Idea of All: Economics is Fun
It teaches us how to make the world a better place.
It’s about the difference between…• Wealth and poverty,• Work and unemployment,• Happiness and squalor.
Increases our understanding of the distant past, present events, and future possibilities.
It is linked to everyday life.• Job• Finances• How to deal with economic events like inflation,
recession, or a bursting stock market bubble.
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Try it!Try it!
As land prices near the U.S. coast increase, what changes do you expect to see in burial practices (other things equal)? Think opportunity cost.
a) Traditional burials will increase and cremation will decrease.
b) Cremation will increase and traditional burials will decrease.
To next To next Try it! Try it!
Try it!Try it!
True or false: As women’s wages have risen over the past 50 years, the opportunity cost of being a stay-at-home mother has risen.
a) Trueb) False
To next To next Try it! Try it!
Try it!Try it!
Would you expect to find companies developing cures for rare diseases or common ones? Think about incentives.
a)Rare diseasesb)Common diseases
To next To next Try it! Try it!
Try it!Try it!
In which country would a person face a lower opportunity cost for holding cash?
a) Zimbabweb) The U.S.
BACK TO
•Second EditionEnd of Chapter 1End of Chapter 1
Second Edition
Chapter 2Chapter 2The Power of TradeThe Power of Tradeand Comparative and Comparative AdvantageAdvantage
Chapter OutlineChapter Outline
Trade and preferences Specialization, productivity, and the
division of knowledge Comparative advantage Trade and globalization
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How is it that farmers in New Zealand wake up at 5 AM to provide you with a Kiwi for your fruit salad?
Answer: Economic cooperation resulting from trade.
We focus on three benefits of trade1. Trade makes people better off.2. Trade increases productivity - specialization 3. Trade increases productivity - comparative
advantage.
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IntroductionIntroduction
Let’s look at these in turn.
WhyWhy We TradeWe Trade
Three benefits of trade1. Trade makes people better off when
preferences (or opportunities) differ.
2. Trade increases productivity through specialization and the division of knowledge.
3. Trade increases productivity through specialization according to comparative advantage.
1. Trade and Preferences1. Trade and Preferences
True power of trade: specialization Reinforcing cycle
• Trade allows specialization.• Specialization increases productivity and
trade. Why does trade increase productivity?
• Trade Increases availability of knowledge.• Knowledge increases productivity.
In a modern economy, more knowledge is used that could exist in a single brain.
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2. Specialization, Productivity, and the 2. Specialization, Productivity, and the Division of KnowledgeDivision of Knowledge
2. Specialization, Productivity, and the 2. Specialization, Productivity, and the Division of KnowledgeDivision of Knowledge
Division of knowledge increases as a market grows.
Modern growth is mainly due to new knowledge.
Important turning point:• Trade is sufficient to support large numbers
of scientists, engineers, and entrepreneurs Increase in world trade can lead to an
increase the division of knowledge.• Fall of the Berlin Wall• Opening of China, Russia, and Europe.
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Comparative AdvantageComparative Advantage Comparative advantage – the ability of a
country to produce a good at lower opportunity cost than another country.
Absolute advantage - the ability of a country to produce a good using fewer inputs than another country.• A country need not have an absolute advantage
in anything to benefit from trade. To understand why, we need to understand
the principle of comparative advantage.
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Warning! Understanding comparative advantage takes effort.
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SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND
SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND
Martha Stewart probably hires housecleaners…. Every hour she spends cleaning (instead of writing about how to keep a clean house) is an hour she doesn’t spend running her empire.
Comparative AdvantageComparative Advantage
The Production Possibility Frontier (PPF)• PPF shows all the combinations of goods that
a country can produce given: Productivity Supply of inputs
• A convenient tool to understand opportunity cost and comparative advantage.
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Let’s apply this tool using an example.
Suppose • in Mexico it requires:
2 units of labor to produce 1 shirt. 12 units of labor to produce 1 computer.
• in the U.S. it requires: 1 unit of labor to produce 1 shirt. 1 unit of labor to produce 1 computer.
• Both countries have 24 units of labor each.
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Comparative AdvantageComparative Advantage
These data are reflected in following tables.
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Comparative AdvantageComparative Advantage
Units of Labor Needed to Produce Units of Labor Needed to Produce Computers and ShirtsComputers and Shirts
Country Computers Shirts
Mexico 12 2
United States 1 1
The U.S. has an absolute advantage in the production of both goods.
PPF curves can be derived from this data.
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Production Possibilities for Mexico and U.S. Production Possibilities for Mexico and U.S. w/o Tradew/o Trade
Mexico United States
2 4 60 108 12
1
2
3
5
4
6
2 4 60 108 12 14 16 18 2220 242
46
108
12141618
2220
24
ShirtsShirts
ComputersComputersNote: 1.The U.S. has an absolute
advantage in both goods.
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Opportunity Costs and Comparative Opportunity Costs and Comparative AdvantageAdvantage
Now suppose that Mexico and the U.S. devote 12 units of labor to the production of each good.
Production = Consumption (no trade)Production = Consumption (no trade)
Country Computers Shirts
Mexico 1 6
United States 12 12
Total Production 13 18
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Production Possibilities for Mexico and U.S. Production Possibilities for Mexico and U.S. w/o Tradew/o Trade
Mexico United States
2 4 60 108 12
1
2
3
5
4
6
2 4 60 108 12 14 16 18 2220 242
46
108
12141618
2220
24
ShirtsShirts
ComputersComputers
No trade: production = Consumption
No trade: production = Consumption
Note: 1.The U.S. has an absolute
advantage in both goods.2.Each country consumes what they produce.
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Opportunity Costs and Comparative Opportunity Costs and Comparative AdvantageAdvantage
Mexico has a comparative advantage in shirts.
U.S. has a comparative advantage in computers
Opportunity CostsOpportunity Costs
Country Opportunity cost of 1 computer
Opportunity cost of 1 Shirt
Mexico 6 shirts 1/6 of a computer
United States 1 shirt 1 computer
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Production Possibilities for Mexico and U.S. Production Possibilities for Mexico and U.S. w/o Tradew/o Trade
Mexico United States
2 4 60 108 12
1
2
3
5
4
6
2 4 60 108 12 14 16 18 2220 242
46
108
12141618
2220
24
ShirtsShirts
ComputersComputers
No trade: production = Consumption
No trade: production = Consumption Slope = 1
24
24
Slope =
6
1
12
2
Shirts have lower opportunityCost in Mexico.
Computers have lower opportunity Cost in the U.S.
Theory of comparative advantage• A country can increase its wealth by…
Specializing in producing goods for which it has a comparative advantage
Trading for the goods for which it does not have a comparative advantage.
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Opportunity Costs and Comparative Opportunity Costs and Comparative AdvantageAdvantage
Let’s continue with our example.
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Opportunity Costs and Comparative Opportunity Costs and Comparative AdvantageAdvantage
Suppose that Mexico specializes completely in shirts U.S. partially specializes partially by producing 14
computers and 10 shirts.
Production in Mexico and U.S. (Specialization)Production in Mexico and U.S. (Specialization)
Country Computers Shirts
Mexico 0 12
United States 14 10
Total Production 14 22
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Opportunity Costs and Comparative Opportunity Costs and Comparative AdvantageAdvantage
With trade the price of both goods will be equal. (assume 1 computer = 3 shirts).
Assume Mexico now consumes 9 shirts and trades the remaining 3 for 1 computer.
Assume the U.S. consumes 13 computers and trades the remaining computers for 3 shirts.
Consumption in Mexico and U.S. Consumption in Mexico and U.S. (Specialization and Trade)(Specialization and Trade)
Country Computers ShirtsMexico 0+1=1 12-3=9
United States 14-1=13 10+3=13
Total Production 14 22
We can now compare trade with no trade using our PPC
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Opportunity Costs and Comparative Opportunity Costs and Comparative AdvantageAdvantage
Mexico United States
2 4 60 108 12
1
2
3
5
4
6
2 4 60 108 12 14 16 18 2220 242
46
108
12141618
2220
24
ShirtsShirts
ComputersComputers
Consumption w/o trade
•Consumption w/trade
•
Consumption w/o trade
Consumption w/trade
Conclusion: Trade allows both countries to consume above their PPC
Conclusions:• Both Mexico and the U.S. gain from trade.
True even though the U.S. has an absolute advantage in both computers and shirts.
Why?• By specializing in goods in which they have a
comparative advantage, each country is using their resources more efficiently.
• Both high productivity and low productivity have some comparative advantage. All countries can benefit from trade.
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Opportunity Costs and Comparative Opportunity Costs and Comparative AdvantageAdvantage
Wages are included in the model• Example:
Wage rate = Consumption/number of workers Suppose Pshirt = $100 and Pcomputer = $300
Conclusion: With trade, wages are higher for both countries!
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Comparative Advantage and WagesComparative Advantage and Wages
MexicoMexico United StatesUnited States
Total Labor 24 units 24 units
Wage Rate Without Trade
Wage Rate With Trade
50.37$
24
6100($1300$
$200
24
12)]($100 12)[($300
$50 24
9)]($100 1)[($300
$217
24
13)]($100 13)[($300
Some Important Points: • The wage in Mexico is lower than the wage in
the U.S. before and after trade. Why? - Productivity of labor is lower in Mexico.
• The increase in wages resulting from specialization and trade is limited by productivity.
Conclusion: Ultimately wages are determined by productivity.
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Comparative Advantage and WagesComparative Advantage and Wages
SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND
SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND
“It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. ….If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.” –Adam Smith
Globalization - the advance of human progress across national boundaries.
Not new• Roman Empire – Knit together large parts of
the world.• “Dark ages” – Trade networks collapsed
when the empire fell.• European Renaissance arose from revitalized
trade routes.
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Trade and GlobalizationTrade and Globalization
The TakeawayThe Takeaway
Power of trade occurs when it leads to specialization.
Specialization leads to increased productivity. Specialization and trade…
• leads to more available knowledge.
• allows taking advantage of economies of scale.
• Increases competition
• Theory of comparative advantage explains how trade can benefit both trading partners.
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Second Edition
End of Chapter 2End of Chapter 2
Second Edition
Consumer ChoiceConsumer ChoiceConsumer ChoiceConsumer ChoiceChapter 23 Chapter 23
Chapter OutlineChapter Outline
How to compare apples and oranges The demand curve The budget constraint Preferences and indifferent curves Optimization and consumer choices The income and substitution effects Applications of income and substitution
effects
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IntroductionIntroduction
In this chapter:• We take a deeper look at how rational
consumers choose. Should they pay a membership fee to shop at
Costco, Sam’s Club, or BJ’s? How much labor should a worker supply in
response to a lower wage.
• Introduce two tools: Budget constraints Indifference curves
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How to Compare Apples and OrangesHow to Compare Apples and Oranges
Apples and oranges produce value, or, “utility”
Marginal utility – the change in utility from consuming an additional unit.
Diminishing marginal utility – means that each additional unit of a good adds less to utility than the previous unit.
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SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND
SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND
How to Compare Apples and OrangesHow to Compare Apples and Oranges
Marginal utilities of apples and oranges• How does this help consumers choose?
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Let’s see.
How to Compare Apples and OrangesHow to Compare Apples and Oranges
The real problem of consumers is to decide how much to spend on each good.
is the marginal utility per dollar spent on apples (“bang per buck”).
Is the marginal utility per dollar spent on oranges.
Total utility will be maximized if:
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O
O
P
MU
A
A
P
MU
O
O
A
A
P
MU
P
MU
Let’s see why.
How to Compare Apples and OrangesHow to Compare Apples and Oranges
If
Total utility will ↑ if the consumer buys more apples and fewer oranges.
If
Total utility will ↑ if the consumer buys more oranges and fewer apples.
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O
O
A
A
P
MU
P
MU
O
O
A
A
P
MU
P
MU
How to Compare Apples and OrangesHow to Compare Apples and Oranges
The optimal consumption rule – to maximize utility, a consumer should allocate spending so that the marginal utility per dollar is equal for all purchases:
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Z
z
i
i
O
O
A
A
P
MU...
P
MU
P
MU
P
MU
Let’s see how this works with a diagram.
Using the Optimal Consumption RuleUsing the Optimal Consumption Rule
If , buy 6 apples and 4 oranges.
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50P
MU
P
MU
O
O
A
A
The Demand CurveThe Demand Curve
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O
O
A
A
P
MU
P
MU
The Budget ConstraintThe Budget Constraint
Budget constraint – shows all he consumption bundles that a consumer can afford given his or her income and their prices.
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IncomeQPQP GGPP
It is easier to see using a diagram.
The Budget ConstraintThe Budget Constraint
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Gasoline(gallons)
Pizza0 2 64
80
8 10 12 14 16
70
50
10
60
40
30
20
0
Income = $100PG = $2 per gallonPP = $10 per pizza
•
This bundle isunaffordable
Any bundle on the line,or, under it is affordable
•
•
The Budget ConstraintThe Budget Constraint
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Gasoline(gallons)
Pizza0 2 64
80
8 10 12 14 16
70
50
10
60
40
30
20
0
Suppose income increases to $140 and prices don’t change.
New budget line
Conclusion: Increases in income result in a parallel shift to the right and up.
The Budget ConstraintThe Budget Constraint
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Gasoline(gallons)
Pizza0 2 64
80
8 10 12 14 16
70
50
10
60
40
30
20
0
sign) negative (ignoring 5 $2
$10
10
50
P
P Slope
G
P
50
10
What happens if PP falls to $6.25?
125.316
50
$2.00
$6.25 Slope
Conclusion: a change in thePrice ratio rotates the budget line.
New budget line
Try it!Try it!
Which graph represents a budget constrain when income=$100, P(gas)=$3, P(pizza)=$20?a)Ab)B
Gasoline (gallons)
Gasoline (gallons)
PizzaPizza
A B
To next To next Try it! Try it!
Try it!Try it!
To next To next Try it! Try it!
Draw a consumer’s budget constraint when the consumer has an income of $100, Pgas = $2 and Ppizza = $10. Now draw the new budget constraint when income = $80.
Draw a consumer’s budget constraint when the consumer has an income of $100, Pgas = $2, and Ppizza =$10. Now draw the budget constraint when Pgas = $4.
Try it!Try it!
To next To next Try it! Try it!
In 1970, the price of pizza is $2.50 and the price of a gallon of gas is $0.50. In 2010, the price of pizza is $10 and the price of a gallon of gas is $2. Has the relative price of pizza changed?
Preferences and Indifference CurvesPreferences and Indifference Curves
Indifference curve – connects all bundles that give the consumer an equal amount of utility.
Marginal rate of substitution (MRS) – the rate at which the consumer is willing to trade one good for another and remain indifferent.
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MRS = slope of the indifference curve at a point
Let’s take a look at some indifference curves.
Preferences and Indifference CurvesPreferences and Indifference Curves
An indifference curve connects all the consumption bundles that give the consumer the same utility.
Driving lots but eating little? You’re willing to give up a lot of gas for one more pizza
Eating lots but driving little? You’re willing to give up very little gas for one more pizza
Slope = MRS = 15
D
C
Slope = MRS = 2.5
A
B
Gasoline (gallons)
Pizza
Preferences and Indifference CurvesPreferences and Indifference CurvesGasoline (gallons)
Pizza
That’s just one indifference curve (signifying one level of utility). How would you show a higher level of utility (assuming more is better)?
Less utility
More utility
Optimization and Consumer ChoicesOptimization and Consumer Choices
Putting it all together…
Consumers want the highest total utility they can afford.
They want to be on the best indifference curve that’s still affordable.
Optimization and Consumer ChoicesOptimization and Consumer Choices
They want to find this….
Optimal
Better but not possible
Possible but not optimal
Gasoline (gallons)
Pizza
Try it!Try it!
To next To next Try it! Try it!
Show that (1) indifference curves can never cross and (2) indifference curves must have a negative slope.
Try it!Try it!
Assume the consumer is currently at point G. Given the budget constraint shown, the consumer would be able to realize more total utility by choosing point ________, all other things held equal.
a)J
b)K
c)I
d)HTo next To next Try it! Try it!
Optimization and Consumer ChoicesOptimization and Consumer Choices
The optimal consumption bundle is on the highest indifference curve but still on the budget constraint.
At this bundle, the slope of the indifference curve is equal to the slope of the budget constraint or:
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gasoline
pizza
P
PMRS
Optimization and Consumer ChoicesOptimization and Consumer Choices
Optimization and Consumer ChoiceOptimization and Consumer Choice
Two interpretations of the optimal consumption rule:• Slope of indifference curve = slope of the
budget line:The rate at which the consumer is willing to trade one good for another equals the rate the consumer must trade one good for another.
• At the optimal bundle, the additional utility per dollar spent is equal for all goods, or:
94gasoline
gasoline
pizza
pizza
P
MU
P
MU
Optimization and Consumer ChoiceOptimization and Consumer Choice
95
Gasoline(gallons)
Pizza0 2 64
80
8 10 12 14 16
70
50
10
60
40
30
20
0
U1
U2
●
Optimal quantity of pizza
Optimalquantityof gas
Suppose Ppizza falls
●
NewBudgetline
The Income and Substitution EffectsThe Income and Substitution Effects
When the price of a good changes, two things happen:• Substitution effect – the change in
consumption caused by a change in the relative price holding utility constant.
• Income effect – the change in consumption caused by the change in purchasing power resulting from a price change.
96
We can use our model to identify these effects.
Income and Substitution EffectsIncome and Substitution Effects
97
Gasoline(gallons)
Pizza0 2 64
80
8 10 12 14 16
70
50
10
60
40
30
20
0
U1
U2
●
●●
To identify the substitution effect, shift the new budget constraint back to tangency with old indifference curve.
Total price effect
A
B
A’Substitutioneffect: A → A’Incomeeffect: A’ → B
Note: the income effectis small
Applications of the Income and Applications of the Income and Substitution EffectsSubstitution Effects
How much should Costco Charge for a Membership?• Costco offers low prices, but you need to pay an
annual membership fee.• Lower prices move customers to a higher
indifference curve.• Paying a membership fee is equivalent to shifting
the new budget line back. The maximum fee a customer will be willing to
pay is the amount that would shift the new budget line back to the old indifference curve.
98Let’s see this.
How Much Should Costco Charge for How Much Should Costco Charge for Membership?Membership?
99
Other Goods
Goods you can buy at Costco
U1Without Costco membership
With Costco membershipHigher
fees
Ide
al
me
mbe
rshi
p
fee
U2
A B••
•A’
TakeawayTakeaway
To maximize utility, allocate dollars such that:
Preferences and constraints come together to shape an outcome.
Understanding income and substitution effects are useful for economic analysis.
When a relative price increases, relative demand for that good will fall.
100
z
z
i
i
O
O
A
A
P
MU...
P
MU
P
MU
P
MU
Second Edition
End of Chapter 23End of Chapter 23